Mixed-use assets. An officials issues paper. August 2011

Transcription

1 Mixed-use assets An officials issues paper August 2011 Prepared by the Policy Advice Division of the Inland Revenue Department and by the New Zealand Treasury

2 First published in August 2011 by the Policy Advice Division of the Inland Revenue Department, PO Box 2198, Wellington. Mixed-use assets an officials issues paper. ISBN

3 CONTENTS CHAPTER 1 Introduction 1 The issue 1 Suggestions 2 Summary of suggested changes 3 Key points for submissions 3 Next steps 4 How to make a submission 4 CHAPTER 2 Legal background and the case for change 5 Statutory provisions 5 Case-law 6 Inland Revenue s guidance 7 The case for change 8 Increasing deductions claimed 9 The need for fairness and certainty 9 CHAPTER 3 Framework for the allocation of expenditure between uses 10 Three-outcome approach 10 Two-outcome approach 11 Comparison between the two approaches 11 Submission point 13 CHAPTER 4 Tests 14 Possible test elements 14 The proposed test(s) 20 Two-outcome approach 20 Three-outcome approach 22 Application of proposals The Johnston family example 23 Submission points 26 CHAPTER 5 Assets subject to the suggested new rules 27 Typical mixed-use assets 27 Other assets 27 Defining what assets the rules will apply to 28 Analysis and suggested approach 30 Submission points 33 CHAPTER 6 Entities subject to the suggested new rules 34 Partnerships (including limited partnerships) 34 Trusts 35 Companies 36 Submission points 43

4 CHAPTER 7 GST treatment of available for use periods 44 Application of the GST rules 44 The issues 45 Assets subject to clarification 46 Possible approach 47 Conclusion 50 Submission points 51 APPENDIX International approaches 52 Australia 52 The United States 53 Canada 54 United Kingdom 54 France 55

5 CHAPTER 1 Introduction 1.1 In Budget 2011 the Government announced its intention to review the tax treatment of assets used for both private and income-earning purposes (mixed-use assets) as part of its ongoing commitment to ensuring fairness across the tax system. 1.2 This issues paper suggests two alternative methods of prescribing deductions for expenditure in relation to these kinds of assets, and seeks readers views on how these methods might work in practice. The issue 1.3 A good example of a mixed-use asset is a holiday home which is used by both the owner and the owner s family for private use, and also rented out. Other assets such as yachts and aircraft can also be used in this way. 1.4 Under the current income tax rules, if the inward cash flows derived from a mixed-use asset are assessable income, the owner can claim deductions for expenditure that was incurred in deriving that income. However, the owner cannot claim a deduction when the expenditure is private in nature. These statutory rules are general and can be difficult to apply to mixed-use assets, in particular when it is not clear whether the expenditure relates to either income-earning use or private use of the asset. 1.5 Expenditure relating to these kinds of assets falls into three categories: Expenditure which relates only to the income-earning use of the asset, such as advertising expenditure. This expenditure is clearly deductible. Expenditure which relates only to the private use of the asset, such as repairs to damage caused by private users. This expenditure is clearly not deductible. Expenditure which relates to the time when the asset is not used. An example would be storage fees for a yacht when it is out of the water. It is not clear whether this expenditure is attributable to either the income-earning use or the private use of the asset. Some expenditure, such as interest, is incurred throughout the year and will fall into all three categories. 1.6 This paper is concerned with the uncertainty that arises around the deductibility of the last category of expenditure described above. 1

6 1.7 In 2009 Inland Revenue issued Guidelines on deductibility of expenditure relating to holiday homes. These guidelines are Inland Revenue s interpretation of the law, but like all guidelines, they have limitations. Guidelines can only offer general advice to owners, and do not have the certainty that specific statutory provisions provide. 1.8 It is not clear whether the correct result is achieved in all circumstances under current law and guidelines. In some instances, owners are claiming deductions which appear to be disproportionate to the income-earning use of assets. An important aspect of our tax system is that it is fair. In this context, owners should only be able to claim deductions when those deductions truly relate to the earning of assessable income. 1.9 This paper outlines two alternative approaches for a set of statutory rules that prescribe and moderate tax deductions for mixed-use assets. Suggestions 1.10 The suggested new rules categorise mixed-use assets into different groups based on the underlying use of the asset, and prescribe the level of deductions that owners in each group can claim. Two possible alternative approaches are suggested: The first uses a single test to identify whether an owner of an asset has an income-earning focus. If the test is passed, the owner would be able to claim all deductions except for expenditure that is directly attributable to actual private use. If the test is failed, the owner will only be able to claim expenditure attributable to actual income-earning use. The second approach includes the income-focused outcome described above, and also an outcome where the owner is only able to claim expenditure attributable to actual income-earning use. However, it also recognises a third, middle category of mixed-use asset, where the asset is used to earn significant income, but also to provide a reasonable level of private use. Expenditure relating to assets in this category is apportioned between deductible and non-deductible The key difference with the second approach is that deductions for expenditure that cannot be easily identified as relating either to private or income-earning use (because it relates to days when the asset is not used) are apportioned based on the level of income-earning and private use. 2

7 Summary of suggested changes The suggested changes moderate deductions which can be claimed in relation to mixed-use assets, primarily those deductions which relate to the time the asset is not being used. Assets will be divided into either two or three categories, depending on how they are used, which will determine the entitlement to claim deductions. (See Chapter 3.) Various tests will set out whether asset owners will be entitled to deductions for all expenditure which relates to periods the asset is not being used, part of that expenditure, or none of it. The tests will consider matters such as: - whether the asset was used for income-earning purposes for 62 days in the income year; - whether the proportion of private use in relation to the income-earning use was less than a given threshold; and - whether the asset was actively marketed. (See Chapters 3 and 4.) The suggested changes will apply only to: - assets which are used for both income-earning purposes and privately rented out on a short-term basis and which are unused for at least two months in every 12; - land and other assets with a cost of $50,000 or more; (See Chapter 5.) - assets ultimately controlled by a small number of individuals that is, assets owned by individuals, partnerships, some trusts, close companies, qualifying companies and look-through companies. (See Chapter 6.) For GST purposes, similar proposals will apply to assets held by GST-registered persons. (See Chapter 7.) Key points for submissions 1.12 Specific issues for comment are set out at the end of each chapter Submissions are also invited more generally on the changes proposed in this paper, such as: Would a simple approach, which has an unavoidable degree of arbitrariness be better than a more complex approach where asset owners circumstances and their tax treatment are more closely matched? 3

8 Next steps Would the criteria outlined for the various tests detailed in this paper be the best way to identify categories of asset owners? Is the proposed tax treatment of asset owners in each category appropriate? Would the suggested changes create unwarranted compliance costs and to what degree? 1.14 Once the consultation period has closed, officials will report to Government, with any legislative changes likely to be introduced to parliament in How to make a submission 1.15 Submissions should be addressed to: Mixed-use assets C/- Deputy Commissioner Policy Policy Advice Division Inland Revenue Department P O Box 2198 Wellington Alternatively, submissions can be made by ing: policy.webmaster@ird.govt.nz with Mixed-use assets in the subject line The closing date for submissions is 30 September Submissions should include a brief summary of major points and recommendations. They should also indicate whether the authors are happy to be contacted by officials to discuss the points raised, if required Submissions may be the subject of a request under the Official Information Act 1982, which may result in their publication. The withholding of particular submissions on the grounds of privacy, or for any other reason will be determined in accordance with that Act. You should make it clear if you consider any part your submission should be withheld under the Official Information Act. 4

9 CHAPTER 2 Legal background and the case for change 2.1 The ability of owners of mixed-use assets to claim deductions for expenditure is a consequence of the current statutory framework, case-law, and Inland Revenue s approach to that statutory framework. The various elements are discussed below. Due to the uncertainty in this area a case for change is presented. Statutory provisions 2.2 Apart from subpart DE of the Income Tax Act 2007, which sets out the rules for motor vehicles there are no specific statutory rules governing deductibility of expenditure relating to mixed-use assets. 1 For all other mixed-use assets, the approach used to determine deductions can only be extrapolated from general statutory rules and case-law. 2.3 The following two statutory rules set out the fundamental requirements for expenditure to be deductible: 2 section DA 1: A person is allowed a deduction for an amount of expenditure or loss (including an amount of depreciation) to the extent to which the expenditure or loss is incurred in deriving their income (both assessable and excluded income) or incurred in the course of carrying on a business for deriving such income; and section DA 2(2): A person is denied a deduction to the extent to which the expenditure is of a private or domestic nature. 2.4 Broadly, a person is allowed a deduction for expenditure incurred in deriving assessable income or in the course of carrying on a business. However, that person is unable to claim a deduction for expenditure that is private in nature. In addition, the rules contain the phrase to the extent. This phrase contemplates that an item of expenditure may be apportioned between the amount that is attributable to income-earning use and the amount attributable to private use. 2.5 These statutory provisions can be difficult to apply to mixed-use assets, since a mixed-use asset has both income-earning and private use elements. Determining what expenditure is attributable to income-earning use, or carrying on a business (deductible expenditure) as opposed to the private use of the asset (non-deductible expenditure) can be difficult when expenditure relates to periods when the asset is not being used. 1 These rules are briefly discussed in Chapter 5, Assets subject to the new proposals. 2 Income Tax Act

10 Case-law Example A holiday home is used by the owners for five weeks per year and is also rented out for five weeks per year. The owner has incurred expenditure that directly relates to the actual private use of the home, the actual rental use of the home, and expenditure that relates to the 42 weeks of the year when the home was not in use. There is no concern about the owner claiming deductions for expenditure which relates to the five weeks per year the home is rented. It is equally clear that no deductions can be claimed for the five weeks per year when the home is used by the owner. The issue is to what extent the owner should be able to claim deductions which relate to the 42 weeks per year the house is empty. 2.6 The leading case on mixed-use assets is CIR v Banks (1978) 3 NZTC 61,236. In this case the taxpayer used a room in his house for income-earning purposes for a certain number of hours per week for a certain number of weeks of the year. The Court of Appeal was asked to consider whether a deduction could be claimed for any proportion of a private home used for income-earning purposes, and held that a deduction could be claimed. However, the Court of Appeal noted that determining an appropriate apportionment calculation was difficult. The Court accepted an apportionment method which provided a deduction for some expenditure relating to periods of non-use. 2.7 In Buckley & Young Ltd v CIR (1978) 3 NZTC 61,271, the taxpayer paid amounts to an employee to obtain the employee s resignation and for a restrictive covenant. The question for the Court of Appeal was whether the expenditure should properly be treated as deductible or on capital account. The Court made some interesting comments about deductions in relation to mixed-use assets: The circumstances of the particular case will usually determine what is the most apt way of deciding how much of the expenditure is attributable to the deductible item. For example, where an asset, such as a house or car, is used for both business and private purposes, the apportionment of total expenses must be fairly based on the use (and some cases availability for use) for business purposes and private purposes respectively. Even so, it is impossible to prescribe any precise formula applicable to all cases. Each such case depends on its own circumstances. It is the yardstick of factual use, or availability for use for business purposes, that satisfies the requirement that the apportionment must be fair not arbitrary, and must be done as a matter of fact. 2.8 Factual use criteria underlie both Inland Revenue s interpretation and suggestions for a new approach in this area, discussed in subsequent chapters. 6

11 2.9 The court later made the following more general comment about apportionment: The more difficult class of case is where each advantage is intangible and does not lend itself to measurement against any conventional yardstick. It then becomes a matter of deciding whether there is any, and if so sufficient, evidence to justify a conclusion that some particular part of the total expenditure is actually attributable to a deductible item, or at least a minimum fractional share of the total expenditure can be realised as so attributable. If there is insufficient evidence to arrive at a conclusion, any answer must be mere speculation and the taxpayer will have failed to discharge the onus of proof upon him This statement is clear authority for a restrictive approach to be taken to allowing deductions relating to expenditure incurred during periods when mixed-use assets are not actually being used. Inland Revenue s guidance 2.11 As noted above, the owners of mixed-use assets other than motor vehicles must apply general law to determine the deductibility of their expenditure. One way to bridge the gap between general provisions and situations which give rise to interpretative difficulty is by way of guidance published by Inland Revenue. While this guidance is not binding on taxpayers or Inland Revenue, it can provide a greater level of certainty than would otherwise exist. Taxpayers typically apply these statements to their situation with a reasonable level of confidence if their circumstances are close to the circumstances described in the guidance In 2009, Inland Revenue released a Questions we ve been asked (QWBA) entitled Holiday houses income tax treatment. It gives guidance to owners of holiday homes on deductions they could claim, and specifically whether they could claim deductions for non-use periods (Tax Information Bulletin, Vol 21, No 3, May 2009). (See also holiday-houses.html.) 2.13 The QWBA indicated that if the holiday house was advertised as genuinely available for use in the empty periods the owner could, in certain circumstances, claim deductions for expenses incurred in these periods. However, when a holiday home was essentially available only to the owner, and the owner s family and friends, and available to rent to third parties on a limited basis, no deduction could be claimed for the period the home was not rented. 7

12 2.14 The QWBA indicated that additional evidence would be required before an owner could claim expenditure for non-use periods: Evidence of a holiday house being available for rent generally needs to be more than a mere statement of its availability, sporadic or limited advertising, or advertising that is of a nature that is unlikely to attract many customers. There must be evidence of active and regular marketing of the holiday house at market rates and of the availability of the holiday house at times and for periods that demonstrate the holiday house is earning rental income or is genuinely available to earn rental income. If a holiday house is available for only limited and/or undesirable periods and/or at non-competitive rates, such factors tend to indicate that the expenditure is not incurred in deriving assessable income Examples were provided to demonstrate the application of the current rules: A holiday home earns significant rental income and is actively marketed, but used by the owners for two weeks over Christmas and New Year. The owners can claim deductions for the entire year with the exception of the two weeks the property is used. A holiday home is used privately for most of the year and rented for two weeks per year. The owners can claim deductions only for the period the holiday home is actually rented out. The case for change 2.16 As discussed, the statutory tests apply to allow a deduction for expenditure incurred in deriving income or in carrying on a business, and deny a deduction for expenditure which is private in nature. However, the application of these statutory rules to expenditure that relates to the time the asset is unused is uncertain. The fundamental difficulty with this type of expenditure is that it could be argued that both sections DA 1 and DA 2(2) of the Income Tax Act 2007 apply to it CIR v Banks and other cases arguably provide support that a deduction for such expenditure is allowable on an apportionment basis, but do not provide detailed rules on how any apportionment is to be applied While Inland Revenue s QWBA guidance is a logical approach to resolving the application of legislative uncertainty in this area, there are some limitations: The guidance applies only to holiday homes, and does not cover other assets which might be both used privately and rented out, such as yachts. The examples given are necessarily limited and cannot cover all situations. 8

13 As with all guidance, only general advice can be provided and taxpayers are free to argue that it does not apply to them. Increasing deductions claimed 2.19 While it has always been possible to rent out these kinds of assets, the practice has increased in recent years for a number of reasons including: Dedicated internet sites for holiday homes make it easier to rent out holiday homes by providing renters with detailed information about properties on offer. A number of yacht charter businesses which market through the internet have been established where private yacht owners can list their yacht. The yacht charter business advertises the boats and arranges for them to be chartered, returning some of the charter fee to the yacht owner. The need for fairness and certainty 2.20 The discussion set out in this chapter illustrates some of the difficulties arising from the current tax deductibility rules for mixed-use assets This situation gives rise to less-than-ideal outcomes in terms of fairness, certainty and economic efficiency, all of which are important elements of a good tax system The remaining chapters of this paper explore options for a new legislative approach to determining the eligibility of owners of mixed-use assets for deductions, with the objective of making the rules fairer, more certain and more economically efficient. 9

14 CHAPTER 3 Framework for the allocation of expenditure between uses 3.1 The suggested new rules categorise mixed-use assets into different groups based on the underlying use of the asset, and prescribe the level of deductions that owners in each group can claim. This chapter considers two alternative frameworks for the proposed changes, namely, the three-outcome approach and the two-outcome approach. 3.2 The two approaches are explained and evaluated below. The details of the tests which make up each approach are discussed in the next chapter. Three-outcome approach 3.3 The three-outcome approach uses two tests to distinguish between three groups of mixed-use asset. The rules prescribe different levels of deductions that owners in each group are able to claim. 3.4 The following outlines each group and the level of deductions each group is able to claim: The private-focused group: The combination of effort and success at earning income is low. In this case, the owner is only able to claim expenditure which relates to the actual income-earning use of the asset, and no deduction can be claimed for expenditure that relates to the time the asset is not used. The genuine mixed-use group: The effort and success in earning income is reasonably high, but there is a greater level of private use than the income-focused group. In this case, the owner is able to claim expenditure which relates to the actual income-earning use of the asset, and a proportion of expenditure that relates to the time the asset is not used can be claimed. The income-focused group: The effort and success in earning income is reasonably high, and private use is limited. In this case, the owner is able to claim expenditure which relates to the actual income-earning use of the asset, and all the expenditure that relates to the time the asset is not used can be claimed The genuine mixed-use group is able claim a proportion of expenditure that relates to the time the asset is not used under a general apportionment rule. The apportionment rule would use the following formula: 10

15 Example Jill uses her holiday home herself for five weeks a year and rents it for five weeks a year. Expenditure relating to the 42 weeks of the year that the holiday home is unused (unused time expenditure) is deductible at a rate of 50% calculated as five weeks income-earning use divided by 10 weeks of total use. Two-outcome approach 3.6 The three-outcome approach can be simplified by removing the genuine mixed-use group under which the apportionment calculation is carried out. This creates the two-outcome approach. This would leave only the privatefocused group, under which unused time is not deductible at all, and the income-focused group, under which all expenditure associated with unused time is deductible. 3.7 All mixed-use assets would be categorised as follows: For those who actively market their asset and have a reasonably low level of private use, deductions would be available for all unused time expenditure. For all others, no deductions would be available for unused time expenditure as the asset has a private-focused outcome. Comparison between the two approaches 3.8 An important difference between the three-outcome model and the twooutcome model is that the test to qualify for the income-focused group would be easier to pass under the two-outcome model. This difference is necessary because the consequence of not falling into the income-focused group in the two-outcome model is denial of all deductions which relate to the time the asset is unused. This can be compared with the three-outcome model which provides apportionment as an outcome for those who combine significant income-earning activity with some private use. 11

16 3.9 This difference is explained in the following diagram: 3.10 The number of people for whom the income-focused outcome would apply is deliberately larger under the two-outcome approach than under the threeoutcome approach. This means those who have a significant income-earning focus but some private use of their asset are likely to prefer the two-outcome approach The reverse is true for those who have an income-earning focus but a larger amount of private use. They are likely to be able to claim a deduction for a proportion of their unused time under the three-outcome approach (where the genuine mixed-use outcome will apply), but no deduction under the twooutcome approach (where the private-focused outcome will apply) What these two differences show is that neither the two-outcome nor the three-outcome approach is, overall, more generous than the other. Those who have either a strong income-earning focus or a strong private use focus will receive the same treatment under either proposal, and those in the middle may prefer one or the other depending on exactly where they fall The three-outcome approach presents a reasonably sophisticated solution that aims to match asset owners individual circumstances with some degree of precision. Compared with the two-outcome approach, there are fewer grounds for arguing that its treatment of asset owners is unfair. However, these advantages must be weighed against the disadvantage of the additional complexity. The three-outcome approach has two tests, rather than the single test of the two-outcome approach. It also includes the apportionment formula, which delivers apportionment percentages specific to each asset owner s circumstances, but which in itself is a reasonably complex tool. 12

17 3.14 By contrast, the two-outcome approach is relatively simple. Only one test need be applied, and the result is that asset owners fall into one of two categories. However, this simplicity results in some degree of arbitrariness. An asset owner at the margin can easily switch from being entitled to deductions for all unused time expenditure, to being entitled to no deductions for any of it, which is a dramatic difference. Submission point Each of the approaches set out above has advantages and disadvantages, and at this stage officials have no strong preference for one over the other. Accordingly, submissions are invited on whether, at a framework level, the two-outcome or threeoutcome approach is preferred. Leaving aside the detail of the tests, do you prefer the three-outcome or the two-outcome framework? Why? 13

18 CHAPTER 4 Tests 4.1 Two possible alternative approaches have been suggested the two-outcome approach, or the three-outcome approach. The outcome of the test(s) will determine the amount of deduction owners can claim. A range of outcomes are possible under either approach, ranging from all expenditure being deductible (other than purely private expenditure) to only expenditure that relates to actual income-earning use being deductible. 4.2 This chapter evaluates the possible contents of the test(s) that determine the amount of deductions asset owners may be able to claim. The test(s) could comprise a number of different elements, from an evaluation of the owner s subjective intentions, to objective requirements based on the actual use of the asset and the behaviour of the owner. Possible test elements 4.3 The test(s) should correctly distinguish between and identify each category of mixed-use asset, and prescribe the correct outcome with a considerable degree of certainty, and without being overly burdensome for owners to comply with. 4.4 The test(s) could contain subjective and/or objective elements. Subjective elements attempt to ascertain the intention of the owner in relation to the asset, and objective elements look at the factual circumstances surrounding the use of the asset. An evaluation of the relative advantages and disadvantages of each element is necessary before a test can be constructed. 4.5 A wide variety of elements are possible, and any combination of these elements can make up the final test or tests. Some suggested elements include: whether the owner had the dominant purpose of earning income from the asset; the common-law business test; whether the asset was actively and regularly marketed as available for use at market rates; whether actual income-earning use or actual private use falls below or above a given threshold; whether private use was merely incidental or necessary to the income-earning use; whether private use of the asset conflicted with the income-earning use of the asset; and whether the incoming receipts exceeded the expenditure. 14

19 4.6 The following is an analysis of the possible elements of the proposed tests. Whether the owner had the dominant purpose of earning assessable income from the asset 4.7 This is a subjective element that would require the owner to declare his or her intention in holding the asset. If the owner has this purpose, the owner could be given a higher amount of deductions. 4.8 The advantages of this element are: It may reveal the owner s intentions in holding the asset. This is an efficient way of getting to an equitable outcome. It may deal appropriately with difficult situations when the asset cannot be rented out because of circumstances such as an adverse natural event. Objective tests based on actual use often fail to accommodate such circumstances. It is likely to be relatively easy for an owner to comply with, as the owner should know his or her own intention. 4.9 However, a purely subjective test relies heavily on the owner s honesty, and that the owner will not falsify his or her intention in order to qualify for an outcome that allows higher deductions. This makes such rules difficult to administer and creates uncertainty for owners as they can be unsure about whether Inland Revenue will accept their stated intention Another issue that arises with this element is the period it would be measured over. Owners can develop intentions regarding the use of the asset on acquisition, each year, or intentions can change during the course of a year. The common-law business test 4.11 The common-law business test contains both a subjective test and a number of useful objective tests that determine whether an income-earning activity equates to a business. If an owner passes the business test he or she is likely to be income-focussed and should qualify for a higher amount of deductions. The common-law business test contains the following elements: what the nature of the activity was; whether the asset was actively marketed; the amount of time, money and effort the person put into the activity; the income earned from the activity; whether the person runs the activity in a similar way to most businesses in the same trade; and whether the dominant purpose of carrying out the activities is to make a profit. 15

20 4.12 The advantage of the common-law business test is that the test is already developed and available for application to the mixed-use asset rules. Furthermore, use of this test for mixed-use assets would align the treatment of mixed-use assets with other tax areas, so bringing the benefits of consistency. The common-law business test also evolves over time ensuring the test is always relevant However, there are some disadvantages associated with the business test. Firstly, it may be difficult to apply to some mixed-use assets. For instance, the rental activities of a single holiday home may never amount to a business. The business test is also a reasonably sophisticated and complex test to apply, requiring a number of different elements to be considered and weighed up. Consequently, the potential application of the business test could be a considerable compliance burden for owners, and is open to challenge by Inland Revenue. This is likely to create uncertainty over the level of deductions owners are able to claim. Genuine efforts to earn income evidenced by active and regular marketing of the asset at market prices 4.14 This element would require the owner of a mixed-use asset to actively and regularly advertise the asset at a market rent, including all periods of non-use for which the asset can reasonably be used. This element attempts to determine whether the asset was genuinely available for income-earning use, and if passed the owner should be entitled to a higher level of deductions In general, periods during which the asset was not in use, and not actively and regularly marketed, would be a strong indication that the asset was not genuinely available for income-earning use. Furthermore, if the asset were advertised at an unreasonably high price in those non-use periods, thereby making it unlikely that anyone would rent the asset, the asset is also arguably not genuinely available for income-earning use during those periods An advantage of this approach is that it is a reasonably accurate way of identifying whether the asset really was available for income-earning use during periods of non-use. A further advantage is that satisfaction of this element is relatively easy to demonstrate However, this element also gives rise to a number of complexities including: What constitutes active and regular marketing? For example, would advertising a holiday home on a website be enough to satisfy the test? What constitutes a market rent? Advertising on its own may not necessarily be a good indication that the asset was genuinely available for use over non-use periods. For example, the owner may choose not to respond to rental enquiries for periods that the owner would like to use the asset privately. 16

21 During what periods should the owner be required to advertise the asset? At certain times it may not be practical to use an asset for income-earning purposes, for instance when repairs and maintenance are carried out, or during times of very low demand. At a minimum the asset should be advertised in periods that demonstrate a genuine income-earning purpose. For example, a ski chalet should be advertised as available for use in the ski season. Actual income-earning use or actual private use is below or above a given threshold 4.18 This objective element is known as a bright-line test. A bright-line test is a clearly defined rule or standard. In this context the owner of a mixed-use asset is prescribed an outcome depending upon whether the actual use of the asset is above or below a given threshold. Similar bright-line tests are used in the United Kingdom and the United States. Examples include: when actual income-earning use exceeds a certain number of days; when actual private use is less than a certain number of days; or when actual private use is less than a given percentage of actual income-earning use If one or more tests are satisfied, the owner could qualify for a higher amount of deductions. The primary advantages of bright-line tests are that they are reasonably simple to understand and comply with, and give owners some certainty over the level of deductions they are likely to be able to claim On the other hand, a bright-line test has dramatic marginal effects. An owner could face starkly different outcomes depending on whether their asset use was above or below the threshold. For example, if the bright-line test was set at 62 days of income-earning use, an owner who had 63 days of actual income-earning use would pass the test and qualify for a higher level of deductions. An owner who only achieved 61 days of actual income-earning use would fail the test and would receive significantly lower levels of deductions. This may be perceived as unfair, as only two days of income-earning use separate the two owners, yet they would receive completely different tax outcomes A bright-line test based on actual income-earning use also assumes that all mixed-use assets would achieve the income-earning threshold if the owner put in a reasonable amount of effort to rent out the asset. This could be an unreasonable assumption. For example, if the bright-line test were set at 93 days of income-earning use, the owner of a ski chalet used predominantly in the winter ski season may genuinely want to earn income from the ski chalet, but is unable to achieve 93 days rental due to a poor ski season that year. This may be perceived as an unfair outcome In practice, different mixed-use assets have different income-earning potential, and therefore a single bright-line test may not be suitable for every asset. However, the application of different bright-line tests for different assets would be complex and would result in difficult boundary issues. 17

22 4.23 Lastly, a bright-line test based on private use could be difficult to enforce. Receipts derived from income-earning use could easily be used to provide proof of that income-earning use. However, evidence proving the existence of private use is more difficult to obtain. Consequently, there would be some risk that owners would understate their private use of the asset in order to qualify for a more generous tax outcome. Private use was merely incidental or necessary to the income-earning use 4.24 This element would attempt to limit private use to those days the private use was incidental to or necessary to the income-earning use. An objective test of this nature is similar to a bright-line test, based on private use. In order for an owner to qualify for generous deductions, the private use of the asset is restricted to a minimum An example of private use that is merely incidental or necessary to the income-earning use would be when the owner stays in his or her holiday house for a couple of days carrying out repairs and maintenance to enhance the income-earning potential of the house A private use restriction along these lines would clearly limit private use substantially. Consequently, the same incentives exist as with a bright-line test for owners to understate their private use of the asset, or to treat all private use as incidental or necessary to the income-earning use. Private use of this nature is arguably not private use at all. There are also definitional problems associated with this test, such as the ambiguity surrounding the term incidental use. Private use of the asset did not conflict with income-earning use 4.27 This element would limit deductions for those owners whose private use of the asset conflicted with income-earning use This element attempts to discover the intention of the owner in holding the asset. If the private use of the asset conflicted heavily with, or took precedence over, the income-earning use, then this is a strong indication that the owner s purpose in holding the asset is predominantly private rather than income-earning This element would require an analysis of the times the asset was used for private purposes, and whether that private use is likely to have conflicted with income-earning use. Example John owns a summer holiday home. The most popular and profitable time to rent out the home is over Christmas and New Year and John receives many offers to rent the home over this period. However, John does not accept these offers, as he wishes to reserve this time for his family and friends to enjoy. 18

23 4.30 This is an example where private use of the house clearly conflicts with the income-earning use. If this element was to form part of the test John would not be able to claim a higher level of deductions 4.31 In practice, determining what periods are the significant income-earning times may be difficult for some assets, as there may be uncertainty over when peak times start and finish. However, some basic generalisations can be made for example, the ski season is the peak time for a ski chalet and the summer months are the peak time for beach-front holiday homes Furthermore, this element could create some uncertainty over when private use of the asset would conflict with income-earning use. An example would be when a holiday home has not been booked for income-earning use for a week over summer and the owners decide to use the house for their private enjoyment. However, after arriving at the house the owner is contacted requesting a booking for that week. If the owner denies the new booking and carries on with the private use of the house, would this be seen as private use conflicting with income-earning use? To cover this situation, this element may have to contain the concept of reasonable notice. Whether the receipts derived from the asset exceed the expenditure 4.33 This element looks at the receipts derived from a mixed-use asset and whether they exceed out-going expenditure. If receipts are larger than the expenditure, this may indicate that the owner had an income-earning focus and therefore the owner could be allowed to claim a higher amount of deductions The advantage of this element is that it is simple to apply because the owner would only need to calculate whether the income raised from the asset exceeded the expenditure associated with it. The owner is already required to gather this information for income tax purposes The main disadvantage of this element is that different results may arise for similar or even identical assets, depending on decisions made by owners about matters such as funding or maintenance costs. For example, an owner who borrowed heavily in order to purchase a holiday house is less likely to have income exceeding expenditure compared with a lower-leveraged holiday house owner, because of the high interest costs. Furthermore, owners may be able to structure their funding between mixed-use assets and other assets they hold to ensure that income exceeds expenditure by the smallest possible amount, to maximise their claim for deductions Finally, this objective element does not accommodate situations when the asset is unable to achieve its full income-earning potential. This might happen if, in a particular year, expenditure on an asset exceeded the incoming receipts because it was taken off the market to undergo repairs and maintenance (which would both reduce the scope for earning income and increase expenditure). 19

24 The proposed test(s) 4.37 From the various elements above, a test or tests can be constructed that distinguish between the different possible outcomes discussed in Chapter 3, and prescribe an appropriate level of deductions. No one element would fully achieve this objective as the elements have particular advantages and disadvantages. Consequently, a combination of different elements is proposed. Two-outcome approach 4.38 The two-outcome approach uses a single test that identifies whether an owner is income-focused and able to claim all deductions except for expenditure that is attributable to actual private use. An income-focused owner is likely to be an owner whose dominant purpose is to rent out the asset, and private use of the asset is minimal. If the owner fails the test, the owner will only be able to claim expenditure that is attributable to actual income-earning use (this is referred to as a private-focused outcome) The proposed test comprises three of the elements discussed previously. The basis for including each element is discussed below. The proposed test, which would apply to each income year, is described in the following diagram: Two-outcome approach Single test The asset is used for actual income-earning for 62 days or more in the income year; and Actual personal use is less than 15% of income-earning use; and There are genuine efforts to earn income for all non-use periods for which the asset can be reasonably used, evidenced by marketing (at market rates) for those periods and positive responses to enquiries. Yes No Income-focused outcome All deductions for expenditure are allowed, except expenditure associated with actual private use. Private-focused outcome Only expenditure associated with actual income-earning use is deductible. Income-earning use bright-line element 4.40 The test contains two bright-line elements. The first of these requires that the asset be used for actual income-earning use for 62 days or more in a year. The 62 days of income-earning use is an attempt to approximate the average income-earning potential of a range of mixed-use assets in New Zealand, for an owner was genuinely serious about earning income from that asset and made genuine efforts to that effect. For example, if an owner of a summer holiday home went to a reasonable amount of effort, and the property was genuinely attractive as a summer holiday home, it is reasonable to assume that the property could be rented for at least 62 days over the summer period. 20

25 4.41 In the context of satisfying the income-earning threshold, a day of actual income-earning use is any day the asset is used by a third party and market rates are paid Generally, officials consider that prescribing a reasonably significant income-earning threshold is justified given the high level of deductions an asset owner receives if they pass the test. Submissions are welcome on whether 62 days is an appropriate threshold. It should be noted, however, that the various elements in the proposed approaches should be viewed as a package. Therefore, any changes to particular elements may warrant related changes to other elements or the addition of another element. Private use bright-line element 4.43 The second bright-line test requires that personal use is less than 15 percent of income-earning use. This threshold has been set relatively low to appropriately target the income-focused group. That is, if the owner s dominant purpose is to rent out the asset, it is reasonable to expect that the private use of the asset will represent a low proportion of actual use. Furthermore, given the high level of deductions that owners can receive if they fall within the income-focused outcome, it is reasonable to limit private use to a low proportion of income-earning use In the context of satisfying the private use threshold, a day of actual private use is any day a mixed-use asset is used or is reserved for use by the owner or an associated person of the owner. This is a necessary requirement in order to prevent owners from understating their private use of the asset in order to gain higher deductions An issue that requires further consideration is how the use of the asset by associated persons in return for market rent should be treated. For example, an owner rents her holiday home to her brother at market rates over the summer holidays. A reasonable argument can be made for treating this period of rental as income-earning use and not private use. That is, the owner will be taxed on the rental income in the same way as if she had rented the home to a non-associated third party, and the owner is not obviously receiving a private benefit from renting the home to her brother. On the other hand, there are examples where it would be clearly inappropriate to count the period an asset is rented to an associate as incomeearning days. For example, a husband rents his holiday home to his wife for market rent This is a difficult area and submissions are welcome on an approach that reflects these concerns but is still able to be applied with a reasonable degree of certainty. Active and regular marketing 4.47 The final element of the test is that the owner must have gone to genuine efforts to earn income for all non-use periods for which the asset can be reasonably used. This should be evidenced by marketing for those periods and a positive engagement with enquiries. This element is essential 21

26 as an owner is unlikely to have the dominant purpose of earning income from an asset if the owner did not advertise the asset The term reasonable has been used in this element as an acknowledgment that it is unreasonable to require owners to advertise the asset in all non-use periods, as in certain circumstances the asset may not practically be able to be used for income-earning purposes. For example, it would not be reasonable for an owner to seek to rent out a yacht for a period when the yacht has been taken out of the water for de-fouling. Three-outcome approach 4.49 The three-outcome approach requires two tests. The first test identifies assets where the focus is on private use, and the second test distinguishes between assets where the focus is on earning income and those which are genuine mixed-use assets. The proposed two tests are as follows: Three-outcome approach Test 1 The asset is used for actual income-earning for 62 days or more in a year; and Genuine efforts to earn income for all non-use periods for which the asset can be reasonably used, evidenced by marketing at market rates for those periods and positive responses to enquiries. Yes Test 2 Actual private use is less than 10% of income-earning use. No Yes No Private-focused outcome Only expenditure that relates to actual income-earning use is deductible. Income-focused outcome All deductions for expenditure are allowed, except for actual private expenditure. Mixed-use outcome Actual income-earning expenditure is deductible. Actual private expenditure is not deductible. A deduction for remaining expenditure is given under the apportionment rule. 22

27 Test Test 1 contains two elements. The first is a bright-line element, setting a minimum level of income-earning use at 62 days in a year. The second element requires that the owner make genuine efforts to earn income for all non-use periods for which the asset can be reasonably used, evidenced by marketing for those periods and positive responses to enquiries. If the owner does not satisfy either element, the private-focused outcome will apply These elements are also features of the two-outcome approach and, the same advantages and disadvantages apply. In addition, the definition of an actual income-earning use day would be the same. Test If the use of the asset successfully meets the first test, the owner is required to apply the second test. The second test determines whether the income-focused or mixed-use outcome should apply. This test contains one bright-line element that limits private use to less than 10 percent of income-earning use. If the asset passes this test (and also passes all the elements in test 1) the asset will be subject to the income-focused outcome. If this test is failed the asset is treated as a genuine mixed-use asset and expenditure for non-use periods is apportioned (the apportionment formula is explained in Chapter 3) The second test is intentionally a difficult test to satisfy. This test should capture only those assets used predominantly for income-earning purposes and therefore attracting the highest amount of deductions. However, it is acknowledged that many income-focused assets may still have a small amount of private use often associated with the income-earning use. Consequently test 2 allows a small amount of private use. Proposed test(s) summary 4.54 The primary objective of the three-outcome approach is similar to the twooutcome approach namely, simplicity and certainty. However, the threeoutcome approach recognises that some assets may be used for genuine mixed-use purposes and therefore their owners should be able to apportion the expenditure incurred that relates to periods the asset is not used. Application of proposals The Johnston family example 4.55 The Johnston family owns a holiday home in the Coromandel. In the 2013 tax year the family actively marketed the house at market rates in newspapers and on internet sites. The house was rented out for 95 days in that year. The Johnston family also used the holiday home themselves for fourteen days over seven weekends during the year. 23